For months now, much has been said about the bond market and the bubble it's in. Every announcement Ben Bernanke makes, the market listens like a poised spring reacting to any clue regarding when quantitative easing (QE) will end. While several pundits claim the bond bubble will burst, I don't share that same view. I have looked through history and cannot find a single period of time when there has been a bond bubble burst. If there is, I'd love to hear about it.
While I don't believe there will be a burst, I do expect a rapid deflation to occur, causing bond yields to rise. Typically, a bubble bursts when fear causes a flight to safety, which is interesting in that the bond markets as a safe haven would generally inflate as a result of this flight to safety. Having said that, the U.S. bond markets are the most overcrowded trade on the planet, and as a safe haven this means it is anything but safe. While I don't expect a bust, I do expect a flight to safety to occur causing a rapid deflation.
For example, let's say someone is holding a 30-year treasury bond with a yield of 2.6% and yields spike to over 4%. This devalues the 2.6% bond, and for it to be attractive to a buyer it has to be sold at a much more attractive rate. Given how overcrowded the bond market is, I expect lots of people will be caught in this dilemma. I can't fathom how so many people are happy to have long-term securities knowing that the inflation-adjusted return will mean they lose money.
During Bernanke's recent speech he hinted at a definite scaling back of the QE program in the foreseeable future. The market reacted immediately and bond yields on 30-year treasuries had a breakout, rising above 3.2%. The notable sign that the bond bubble is in its deflationary phase is how the S&P 500 has retraced, yet bonds yields are continuing to rise.
Click to enlarge images.
So now that we are bearish bonds (bullish yields), how does one make a play on this? There are several options available to us. However, I will discuss just a couple of them. I was at a conference recently where there were quite a number of people bearish bonds, but they mostly only knew the one way to trade it. This was via the ETFs iShares Barclays 20+ Year Treasury Bond Fund (NYSEARCA:TLT), Proshares Ultrashort 20+ Year Treasury (NYSEARCA:TBT), and Direxion 20+ Year Treasury Bear 3X (NYSEARCA:TMV), with most opting for TMV. TMV is a triple-leveraged fund providing 300% movement compared with its unleveraged counterpart.
Trading TMV has the potential for explosive returns, but it is also very dangerous to the uninitiated -- I haven't called it the "widow maker" for no reason. Reading the fact sheet for the TMV ETF, it clearly warns that it is not for long-term exposure. The real problem that most people aren't aware of is the slippage/decay inherent in it. It is easy to look at TMV trading around the $60 level now and think, "Wow, when yields were higher it was trading around $450." It would be fatal to think that it is going to return to that level (don't be fooled by the impressive-looking chart above). How so?
Let's look at the following as an example. Assume TMV is trading at $100 and its non-leveraged counterpart is trading at the same figure. For this exercise I will call it XYZ. Let's say XYZ dropped 10% in price and thus TMV 30% (due to its triple leveraging). The following would apply:
XYZ - $90.00 TMV - $70.00
The following day, XYZ moves up 11% (therefore TMV 33%).
XYZ - $99.90 TMV - $93.10
So, from looking at the above, while exaggerated you can see that XYZ has lost virtually no value (0.1%) but TMV has lost a staggering 6.9%. You can now see that if the market range trades for a period of time, this will be detrimental to your profitability. I am definitely not saying don't trade TMV, but understand how it operates and the risks associated with it.
Shorting bonds on the futures market is another way to make this trade. My preferred method is the eurodollar via futures contracts or contract options. Given the limited downside risk, I am trading future contracts over options. The eurodollar has nothing to do with the euro, and I suggest reading up on it to understand how its value is derived. The eurodollar, in simple terms, trades the three-month U.S. interest rate for U.S. dollars held outside of the U.S.
With interest rates at such low levels I'm happy to trade this instrument and hold for the longer term. This is a definite trade with limited downside and huge upside potential. Every 100 points of movement equates to $2,500 per contract -- i.e., a move from 99.00 to 98.00. Assuming interest rates don't go into negative territory, I'm happy to keep stacking my position if interest rates were to retrace.
Looking at the above chart (December 2013 eurodollar futures), there is no way the value of the eurodollar will go above 100 unless the Fed announces negative interest rates. So you can see my excitement -- a risk of a few basis points vs. the potential gain of hundreds of them.
Disclosure: I am long TMV. I am short eurodollars via futures contracts. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.